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As China’s economic growth slows and begins to stagnate, there is one direction that many eyes are focused upon as the culprit - zombie companies.

A zombie company is a state-owned enterprise - usually in the industrial sector - that continues operating despite being either insolvent or near bankruptcy but is propped up with money from the government and banks.

The reasons the Chinese government does this are well intentioned. By doing so, they maintain social stability and keep down joblessness, and often keep factories open that are vital to the economy. However, the practice also often causes far wider problems for the economy. China currently has the highest level of corporate debt as a share of GDP in the world, at a record 237% of GDP in the first quarter, due primarily to a massive lending program designed to boost economic growth. Zombie companies account for roughly $24.7 billion of this debt, and should they default, as is likely, analysts warn the shocks could have a global impact.

Patrick Chovanec of Silvercrest Asset Management, an expert on the Chinese economy, points out similarities between the China of today and Japan in the 1980s, noting: ‘There are striking similarities between China and Japan in the 1980s and ’90s, and they’re not superficial. They’re two very different countries but they ended up with a banking system that basically produces the same result—the outcome being a rapid deceleration of (hitherto high) growth, as well as zombie banks and corporations.’

The financial impact is already being seen in China. Credit Suisse recently warned that interest cover was less than one in nearly 70% of listed Chinese steel and aluminum companies they covered and more than 50% of coal companies for the first three quarters of 2015. This is worrying for supply chains as it is reasonable to assume that these struggling companies could be among your suppliers, or supply to them. Zombies present a profound impact to visibility as it is highly unlikely the actual health of the business is being reported, leaving any financial risk impossible to detect.

China's top state-owned asset administrator has vowed to clean-up zombie industrial companies by 2020, with Zhang Yi, Chairman of the State-owned Assets Supervision and Administration Commission (SASAC), committing to resolving the issue over the next three years. Earlier this year, President Xi Jinping also announced a series of moves designed to cut industrial capacity and cull zombie corporations. These efforts have seen some success. Courts in China accepted 1,028 bankruptcy cases in the first quarter of 2016, up 52.5% from a year earlier, according to the Supreme People’s Court. Just under 20,000 cases were accepted in total between 2008 and 2015. The impact is highly likely to reverberate down supply chains, particularly if the shuttered supplier is the sole supplier of a specific part.

For supply chain managers, it is vital you know who your supply chain partners and have total transparency as to any financial issues they may be facing. Pressure is mounting on the Chinese government to resolve the issue of zombie companies, and the likelihood that many more will default is extremely high.